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Chapter16: Accounting for Income Taxes

Intraperiod Tax Allocation

You should recall that an income statement reports certain items separately from income (or loss) from continuing operations when such items are present. Specifically, (a) discontinued operations and (b) extraordinary items are given a place of their own in the income statement to better allow the user of the statement to isolate irregular components of net income from those that represent ordinary, recurring business operations. Presumably, this permits the user to more accurately project future operations without neglecting events that affect current performance.19 Following this logic, each component of net income should reflect the income tax effect directly associated with that component.

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p. 903

   Consequently, the total income tax expense for a reporting period should be allocated among the income statement items that gave rise to it. Each of the following items should be reported net of its respective income tax effects:

   

  

Income (or loss) from continuing operations.

  

Discontinued operations.

  

Extraordinary items.

The related tax effect can be either a tax expense or a tax benefit. For example, an extraordinary gain adds to a company's tax expense, while an extraordinary loss produces a tax reduction because it reduces taxable income and therefore reduces income taxes. So a company with a tax rate of 40% would report $100 million pretax income that includes a $10 million extraordinary gain this way:

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A gain causes an increase in taxes.

   If the $100 million pretax income included a $10 million extraordinary loss rather than an extraordinary gain, the loss would be reported net of associated tax savings:

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A loss causes a reduction in taxes.

  
ADDITIONAL CONSIDERATION

If the extraordinary gain in the earlier example had been of a type taxable at a capital gains tax rate of 30%, it would have been reported net of the specific tax associated with that gain:

Extraordinary gain (net of $3 income tax expense)      $7

  

   Allocating income taxes among financial statement components in this way within a particular reporting period is referred to as intraperiod tax allocation. You should recognize the contrast with interperiod tax allocation—terminology sometimes used to describe allocating income taxes between two or more reporting periods by recognizing deferred tax assets and liabilities. While interperiod tax allocation is challenging and controversial, intraperiod tax allocation is relatively straightforward and substantially free from controversy.

Allocating income taxes within a particular reporting period is intraperiod tax allocation.

OTHER COMPREHENSIVE INCOME.    Allocating income tax expense or benefit also applies to components of comprehensive income reported separately from net income. You should recall from our discussions in Chapters 4 and 12 reveal that “comprehensive income” extends our view of income beyond conventional net income to include four types of gains and losses that traditionally haven't been included in income statements. The other comprehensive income (OCI) items relate to investments, postretirement benefit plans, derivatives, and foreign currency translation. When these OCI items are reported in a statement of comprehensive income and then accumulated in shareholders' equity, they are reported net of their respective income tax effects in the same way as for discontinued operations and extraordinary items.

p. 904

INTERNATIONAL FINANCIAL REPORTING STANDARDS

 

Extraordinary Items. Recall from Chapter 4 that extraordinary items are not reported separately under IFRS. IAS No. 1, “Presentation of Financial Statements,” states that neither the income statement nor any notes may contain any items called “extraordinary.”20 As a result, according to IFRS the only income statement item reported separately net of tax is discontinued operations.

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DECISION MAKERS' PERSPECTIVE

Income taxes represent one of the largest expenditures that many firms incur. When state, local, and foreign taxes are considered along with federal taxes, the total bite can easily consume 40% of income. A key factor, then, in any decision that managers make should be the impact on taxes. Decision makers must constantly be alert to options that minimize or delay taxes. During the course of this chapter, we encountered situations that avoid taxes (for example, interest on municipal bonds) and those that delay taxes (for example, using accelerated depreciation on the tax return). Astute managers make investment decisions that consider the tax effect of available alternatives. Similarly, outside analysts should consider how effectively management has managed its tax exposure and monitor the current and prospective impact of taxes on their interests in the company.

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   Consider an example. Large, capital-intensive companies with significant investments in buildings and equipment often have sizable deferred tax liabilities from temporary differences in depreciation. If new investments cause the level of depreciable assets to at least remain the same over time, the deferred tax liability can be effectively delayed indefinitely. Investors and creditors should be watchful for situations that might cause material paydowns of that deferred tax liability, such as impending plant closings or investment patterns that suggest declining levels of depreciable assets. Unexpected additional tax expenditures can severely diminish an otherwise attractive prospective rate of return.

Investment patterns and other disclosures can indicate potential tax expenditures.

   You also learned in the chapter that deferred tax assets represent future tax benefits. One such deferred tax asset that often reflects sizable future tax deductions is an operating loss carryforward. When a company has a large operating loss carryforward, a large amount of future income can be earned tax free. This tax shelter can be a huge advantage, not to be overlooked by careful analysts.

Operating loss carryforwards can indicate significant future tax savings.

   Managers and outsiders are aware that increasing debt increases risk. Deferred tax liabilities increase reported debt. As discussed and demonstrated in the previous chapter, financial risk often is measured by the debt to equity ratio, total liabilities divided by shareholders' equity. Other things being equal, the higher the debt to equity ratio, the higher the risk. Should the deferred tax liability be included in the computation of this ratio? Some analysts will argue that it should be excluded, observing that in many cases the deferred tax liability account remains the same or continually grows larger. Their contention is that no future tax payment will be required. Others, though, contend that is no different from the common situation in which long-term borrowings tend to remain the same or continually grow larger. Research supports the notion that deferred tax liabilities are, in fact, viewed by investors as real liabilities and they appear to discount them according to the timing and likelihood of the liabilities' settlement.21

Deferred tax liabilities increase risk as measured by the debt to equity ratio.

p. 905

   Anytime managerial discretion can materially impact reported earnings, analysts should be wary of the implications for earnings quality assessment. We indicated earlier that the decision as to whether or not a valuation allowance is used, as well as the size of the allowance, is largely discretionary. Alert investors should not overlook the potential for “earnings management” here. In fact, recent empirical evidence indicates that some companies do use the deferred tax asset valuation allowance account to manage earnings upward to meet analyst forecasts.22

   In short, managers who make decisions based on estimated pretax cash flows and outside investors and creditors who make decisions based on pretax income numbers are perilously ignoring one of the most important aspects of those decisions. Taxes should be a primary consideration in any business decision.

CONCEPT REVIEW EXERCISE

MULTIPLE DIFFERENCES AND OPERATING LOSS

Mid-South Cellular Systems began operations in 2011. That year the company reported taxable income of $25 million. In 2012, its second year of operations, pretax accounting income was $88 million, which included the following amounts:

1.

 

Insurance expense of $14 million, representing one-third of a $42 million, three-year casualty and liability insurance policy that is deducted for tax purposes entirely in 2012.

2.

 

Insurance expense for a $1 million premium on a life insurance policy for the company president. This is not deductible for tax purposes.

3.

 

An asset with a four-year useful life was acquired last year. It is depreciated by the straight-line method in the income statement. MACRS is used on the tax return, causing deductions for depreciation to be more than straight-line depreciation the first two years but less than straight-line depreciation the next two years ($ in millions):

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4.

 

Equipment rental revenue of $80 million, which does not include an additional $20 million of advance payment for 2013 rent. $100 million of rental revenue is reported on the 2012 income tax return.

The enacted tax rate is 40%.

Required:

1.

 

Prepare the journal entry to record Mid-South Cellular's income taxes for 2012.

2.

 

What is Mid-South Cellular's 2012 net income?

3.

 

Show how any deferred tax amount(s) should be reported in the 2012 balance sheet. Assume taxable income is expected in 2013 sufficient to absorb any deductible amounts carried forward from 2012.

p. 906

SOLUTION

1.

 

Prepare the journal entry to record Mid-South Cellular's income taxes for 2012.

Differences in tax reporting and financial reporting of both the prepaid insurance and the depreciation create future taxable amounts.

Both the advance rent and the operating loss carryforward create future deductible amounts.

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   *2011's only temporary difference.

Income tax expense is composed of three components: (1) the tax deferred until later, reduced by (2) the deferred tax benefit and (3) the refund receivable of 2011 taxes paid.

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Note: Adjusting pretax accounting income by the permanent difference and the three temporary differences creates a negative taxable income, which is a net operating loss.

2.

 

What is Mid-South Cellular's 2012 net income?

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3.

 

Show how any deferred tax amount(s) should be reported in the 2012 balance sheet. Assume taxable income is expected in 2013 sufficient to absorb any deductible amounts carried forward from 2012.

p. 907

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   *Deferred tax asset classified entirely as current because 2013 income is expected to be sufficient to realize the benefit of the carryforward.

No net current amount
Long-term liabilities:
Deferred tax liability
$64.8

Note: These net amounts ($0.0 + 64.8 = $64.8) sum to the net total deferred tax liabilities and deferred tax assets from requirement 1 ($76.0 − 11.2 = $64.8).



FINANCIAL REPORTING CASE SOLUTION

1.

 

What's the difference? Explain to Laura how differences between financial reporting standards and income tax rules might cause the income tax expense and the amount of income tax paid to differ. (p. 874)  The differences in the rules for computing taxable income and those for financial reporting often cause amounts to be included in taxable income in a different year(s) from the year in which they are recognized for financial reporting purposes. Temporary differences result in future taxable or deductible amounts when the temporary differences reverse. As a result, tax payments frequently occur in years different from the years in which the revenues and expenses that cause the taxes are generated.

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2.

 

What is the conceptual advantage of determining income tax expense as we do?(p. 874)  Income tax expense is the combination of the current tax effect and the deferred tax consequences of the period's activities. Under the asset-liability approach, the objective of accounting for income taxes is to recognize a deferred tax liability or deferred tax asset for the tax consequences of amounts that will become taxable or deductible in future years as a result of transactions or events that already have occurred. A result is to recognize both the current and the deferred tax consequences of the operations of a reporting period.

3.

 

Are there differences between financial reporting standards and income tax rules that will not cause a difference between income tax expense and the amount of income taxes paid? (p. 886)  Yes. Some differences between accounting income and taxable income are caused by transactions and events that will never affect taxable income or taxes payable. These differences between accounting income and taxable income do not reverse later. These are permanent differences that are disregarded when determining (a) the tax payable currently, (b) the deferred tax effect, and therefore (c) the income tax expense. <a onClick="window.open('/olcweb/cgi/pluginpop.cgi?it=jpg::::/sites/dl/premium/0077328787/student/818573/ora.jpg','popWin', 'width=NaN,height=NaN,resizable,scrollbars');" href="#"><img valign="absmiddle" height="16" width="16" border="0" src="/olcweb/styles/shared/linkicons/image.gif"> (0.0K)</a>




19We discussed this in Chapter 4.

20“Presentation of Financial Statements,” International Accounting Standard No. 1 (IASCF), as amended effective January 1, 2009.

21See Dan Givoly and Carla Hayn, “The Valuation of the Deferred Tax Liability: Evidence from the Stock Market,” The Accounting Review, April 1992, pp. 394–410.

22Sonia O. Rego and Mary Margaret Frank, “Do Managers Use the Valuation Allowance Account to Manage Earnings Around Certain Earnings Targets?” April 16, 2004, Darden Business School Working Paper No. 03-09.

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